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Learning objectives

Chapter 3: 

Fraud and Error
Internal Control
Fundamental  Materiality and Audit risk
 Management Assertion, Audit Evidence
concepts in auditing and Audit Files
 Professional Judgement and Professional
Skepticism

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What is Fraud? Types of

FraudReporting (“management
Fraudulent Financial
 Fraud is an intentional act by one or more individuals among fraud”)
management, those charged with governance, employees, or  Misrepresentation in, or intentional omission
third parties, involving the use of deception to obtain an from, the financial statements of events,
unjust or illegal advantage.
transactions, or other significant information
 Manipulation, falsification or alteration of
 Two types (In the context of auditing ): records or documents from which financial
» Misstatements resulting from fraudulent financial statements are prepared
reporting  Intentional misapplication of accounting
principles relating to amounts, classification,
» Misstatements resulting from misappropriation of assets. manner of presentation, or disclosures.

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Bookkeeping scandals
Types of Fraud - cont
Misappropriation of assets
“employee fraud”
 Misappropriation of assets – often
accompanied by false or misleading
records in order to conceal that the
assets are missing
Examples include:
 Embezzling receipts
 Stealing physical assets or October
intellectual property 16, 2001
June 20, 2002 September, 2003 March 28, 2002

 Payroll fraud
Issue: Off-Balance Issue: Financial Issue: Financial Issue: Financial
 …… Sheet Accounting Reporting Fraud Reporting Fraud and Reporting Fraud
and Financial inappropriate and embezzlement
Reporting Fraud consolidation
Impact: $9 billion
Impact: $3 billion in in unreported Impact: $2.5 billion
Impact: $ millions in
undisclosed losses expenses of hidden debt
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Causes of Fraud
– Fraud What is Error?
Triangle
Unintentional mistakes in financial
information such as:
Attitudes/Rationalizations
 Errors of commission: mathematical or clerical mistakes
in the recording and accounting data;
 Errors of omission: transactions, events is left out of an
Fraud accounting statement by mistake.
Triangle  Errors of principle: misapplication or misunderstanding
of accounting policies unintentionally. Ex: wrong allocation
between different accounts, wrong valuation of assets,…
Incentive/Pressures Opportunities

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The following misstatements are included in the accounting records

Causes of accounting of the Joyce Manufacturing Company:

1. A sales invoice was miscalculated by $1,000 as a result of a key-entry
mistake.
errors 2. Cash paid on accounts receivable that had been prelisted by a secretary was
stolen by the bookkeeper who records cash receipts and accounts receivable. He
 Pressures: Time pressure in the process of failed to record the transactions.
recording accounting transaction, pressure of 3. A material sale was recorded on the last day of the year even though the
working environment,… goods were not shipped until 3 days later.
4. Merchandise was shipped to a customer, but no bill of lading was prepared.
Because billings are prepared from bills of lading, the customer was not billed.
 Working style of accountants : Careless or 5. A sale to a residential customer was unintentionally classified as a
commercial sale.
negligent, distraction,.. 6. The shipping clerk included several additional valuable items to a shipment
that were not included in the customer’s order and were not invoiced to the
customer. The shipping clerk has an arrangement with the customer to share the
 Limited qualification of accountants proceeds from sales of the additional items shipped.
7. Cash paid on accounts receivable was stolen by the mail clerk when the mail
was opened.
Required: Identify whether each misstatement is an error or fraud.
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Fraud & Error Fraud and error

Similarities:
 results in the misstatement in the financial statements
Distinguish between fraud and error  the primary responsibility for the prevention and detection of
fraud and error rests with both those charged with
- Similarity governance and the management of an entity.
- Difference Differences:
Fraud Error
Act Intentional Unintentional
Sophisticated Difficult to detect => carefully Easy to detect => not
level to detecting organized schemes hide mistake
misstatements (sophisticated schemes)
designed to conceal fraud.
Materiality of materiality Depend on nature and
misstatements
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Responsibility for Prevention & Detection Responsibility for Prevention & Detection

Auditor’s Responsibility
Management Responsibility  The auditor should consider the risk of material
 The primary responsibility for the prevention and misstatements in the financial statements resulting from
detection of fraud and error rests with both those fraud or error.
charged with governance and the management of an
entity. The respective responsibilities may vary from  An auditor cannot obtain absolute assurance that material
entity to entity.
misstatements in the financial statements will be detected. The
 The management is responsible for establishing and
auditor is able to obtain reasonable assurance that material
maintain policies and procedures by implementing
and ensuring continued operation of accounting misstatements in the financial statements will be detected.
and internal control systems, which are designed to
detect and prevent fraud and error.

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True/False question:
Internal control
1. Fraud may be results of negligence whereas error is
intentional A system of internal control consists of policies and
2. The principal difference fraud and error is the intentional or procedures designed to provide management with
unintentional act. reasonable assurance that the company achieves its
3. The auditor has responsibility for detecting all fraud and objectives and goals.
errors in financial statement.
4. The auditor has only responsibility for detecting and Main objectives of a system of internal control:
preventing the material misstatement due to fraud. 1. Reliability of Reporting
5. The auditor has to provide absolute assurance that figures 2. Efficiency and Effectiveness of Operations
in financial statement are correct. 3. Compliance with Laws and Regulations
6. Intentional overstatement of income is error of omission
7. Theft of intangible fixed asset is misstatement from
fraudulent financial reporting Copyright ©2017 Pearson Education, Inc.

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Coso components of internal control Materiality

COSO’s Internal Control—Integrated Framework
Developed in 1992 and updated in 2013 and 2017 Materiality is the magnitude of
The COSO Framework describes five components an omission or misstatement of
of internal control: accounting information that, in
the light of surrounding
1. Control environment 4. Information circumstances, make it probable
and communication that the judgment of reasonable
2. Risk assessment 5. Monitoring person relying on the
3. Control activities information would have been
changed or influenced by the
omission or misstatement.

Copyright ©2017 Pearson Education, Inc.

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Materiality Evaluating Materiality

 Quantitative materiality level
 Materiality is a relative rather than No official guidelines within auditing standards
Bases for evaluating Materiality
absolute concept  5-10% of Net Income before Taxes
 ½-1% of Total Assets
 Materiality includes both quantitative
 ½-1% of Total Revenue
and qualitative consideration (size and  1- 2% of Equity
Auditor add up all individually immaterial
nature of the misstatement) misstatements in order to detect material
misstatement in aggregate.

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Study break Evaluating Materiality

Page 233: Figure 8.4 – Income Statement of Hillsburg
Hardware  Qualitative Considerations
 Bases for evaluating Materiality - Amount involve fraud are usually more important than
unintentional errors of equal dollar amounts => reflect on
 5-10% of Earnings before Income Taxes
honest and reliability of management.
 ½-1% of Total Assets
- Misstatements that are otherwise minor may be material
 ½-1% of Total Revenue if there are consequences influenced related significant
Requirement: Set the materiality for FS as a whole or accounts
preliminary judgement about materiality. - Misstatements that are otherwise immaterial if they
Explain the materiality level set. affect a trend in earning.
- Note: Materiality is a matter of Professional Judgement

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Exercises:
Study Break
Any amount of misstatement that is less than the For each of the following statements select whether they
are true or false :
level of materiality would be referred to as:
a. Quantitative misstatement 1. Materiality depend only on the monetary amount of
an item.
b. Material misstatement 2. Materiality may depend on either the nature of an
c. Immaterial misstatement item or its monetary amount.
3. Materiality is a matter of judgment.
d. Probable misstatement 4. Materiality is always expressed as proportion of profit
5. Materiality should be calculated at the planning stage
of all audits.
6. Materiality will influence the audit opinion given.
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Audit Risk Accepted audit risk

 Audit risk means the risk that the auditor  Accepted audit risk is a measure of how
gives an inappropriate audit opinion willing the auditor is to accept that the
when the financial statements are financial statements may be materially
materially misstated. misstated after the audit is completed
 It’s not practical totally eliminate audit and an inappropriate opinion has been
risk => minimize the risk to extent issued.
possible (accepted audit risk)  For many audit firms, accepted audit risk
is 5% or lower (1% or ½%,…)

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Accepted audit risk Audit Risk

Risk of Material Risk that the Auditors
Audit Risk = Misstatement * Fail to Detect
AAR = 5%?????????????? the Misstatement

Same as audit assurance = 95%

= Inherent Control Detection
Risk * Risk * Risk

Risk of material misstatement: The risk that the

financial statements contain a material
misstatement due to fraud or error prior to the
audit.
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Inherent Risk Control Risk

 Inherent Risk: Risk of a material

misstatement occurring in an assertion
assuming no related internal controls.
 Factors affecting inherent risk: Operating
and industry characteristics, management  Control Risk--Risk that a material misstatement
characteristics, inexperience and laxity in an assertion will not be prevented or detected
accounting personnel, engagement on a timely basis by the company’s internal
characteristics … control.
 Auditors assess CR through evaluating the
 Auditors assess IR , do not manage the IR
effectiveness of internal control system.
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Detection Risk Illustration of Audit Risk

Detection Risk--Risk that the
auditors’ procedures will lead them
to conclude that a material
misstatement does not exist in an
assertion when in fact such
misstatement does exist.
Auditors can control DR => have
responsibility to reduce DR by
performing substantive tests

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Audit Risk Formula

Audit Risk Model Solving for Detection Risk

AR
Risk of Material Risk that the Auditors DR 
Audit Risk = Misstatement * Fail to Detect IR  CR
the Misstatement
 Implications
» Assuming constant, sufficiently low AR, detection risk
= Inherent Control Detection
Risk * Risk * Risk is inversely related to IR and CR

↑ combined IR and CR ↓ allowed DR ↑ substantive

evidence
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Exercises
For each of the following example select the type of risk Interrelationship of the components of audit risk
illustrated:
1. The auditor will be using sample in testing
2. The client is seeking to raise finance for new venture Assessment of Control Risk
3. The client has a number of estimates in its financial Detection risk matrix
statements.
High Medium Low
4. Senior management regularly override system of controls
5. The clients fail to reconcile bank account to recorded
cash balances. High Low Low Medium
6. The audit program omits several necessary audit
Assessment of
procedures. Medium Low Medium High
Inherent Risk
7. The client engages in several material transaction with
entities owned by family members of several of the Low Medium High High
client’s senior executives.
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Calculating the DR Management assertion

If inherent risk and control risk are assumed to
be 60% each, in order to prevent the overall  Management assertion are
audit risk from exceeding 10%, detection risk implied and expressed
has to be set at ? %. representations by management
about classes of transaction and
Working related accounts in the financial
Audit Risk = IR x CR x DR statements.
0.10 = 0.60 x 0.60 x Detection Risk  These assertions are part of the
0.10 = Detection Risk = 0.278 = 27.8% criteria that management uses to
0.36 record and disclose accounting
information in financial statements

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Management Assertions Embodied in Management Assertions for

the Financial Statements Each Category of Assertions
 Existence or Occurrence--Assets, liabilities, and owners’ equity accounts
Transactions and Events Account Balances Presentation and Disclosure
reflected in the financial statements exist; the recorded transactions have
occurred. Occurrence Existence Occurrence and rights
 Completeness--All transactions, assets, liabilities, and elements of owners’ and obligations
equity that should be presented in the financial statements are included.
Completeness Completeness Completeness
 Rights and Obligations--The client has rights to assets and obligations to
pay liabilities that are included in the financial statements. Accuracy Valuation and Accuracy and
 Valuation or Allocation--Assets, liabilities, owners’ equity, revenues, and allocation valuation
expenses are presented at amounts that are determined in accordance with Classification Classification and
generally accepted accounting principles.
 Presentation and Disclosure--Accounts are described and classified in the
understandability
financial statements in accordance with generally accepted accounting Cutoff
principles, and all material disclosures are provided.
Rights and
 Accuracy – Amounts and other data relating to recorded transactions have
been recorded properly.
obligations

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Relationship of Financial Statement

What is the audit evidence?
Assertions and the Audit

Financial
Statements Management
Audit Objectives
(GAAP) Assertions

 AE is the information obtained by the auditor in arriving

Audit Report on at the conclusions on which the audit opinion is based.
Audit Evidence Financial  AE includes source documents and accounting
Audit Procedures
Statements
records underlying the financial report and
corroborating information from other sources.

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Audit Sufficiency
evidence
 Sufficiency is the measure of the quantity
 The auditor should obtain sufficient
of audit evidence
appropriate audit evidence to be able to
 Affecting to sufficiency of audit evidence
draw reasonable conclusions on
which to base the audit opinion  Audit evidence’s quality: the higher quality…., the
less…
Sufficient audit evidence
 Materiality: the more… the more…
 Appropriate audit evidence
 Audit Risk: the greater… the more…

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Affecting to appropriateness
Appropriateness of audit evidence
 Types of evidence
 Appropriateness relates to the
 Source of evidence (independence of
relevance and reliability of audit
evidence provider)
 Internal control system’s effectiveness
 Audit direct knowledge
 Or appropriateness is the measure of
quality of audit evidence relevance to  Qualification of individual
a particular assertion and its reliability  Interrelation of evidence

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Appropriateness of Audit Evidence Short Exercise

The following are examples of documentation

Principles—Audit evidence is ordinarily more obtained by the auditors:
reliable when it is 1. Duplicate copies of sales invoices
Obtained from knowledgeable independent sources
2. Purchase orders
outside the company rather than nonindependent
sources (source inside the company) 3. Bank confirmation
Generated internally through a system of effective 4. Vendors’ invoices
controls rather than ineffective controls. 5. Shipping document
Obtained directly by the auditor rather than indirectly or 6. Long – term debt agreements
by inference  Classify each document as internal evidence or
Documentary in form rather than oral external evidence, as to its reliability (high,
Provided by original documents rather than copies moderate or low).
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Audit Documentation Functions of Audit Documentation

 Provide support for the auditors’ opinion

 Definition: Audit documentation is the  Document the auditors’ compliance with
record of the audit procedures, performed, generally accepted auditing standards,
relevant audit evidence, and conclusion the especially the standards of field work
auditor reached.  Provide a means of assigning and coordinating
audit work
 Audit documentation may also be referred  Aid in supervising and reviewing the audit work
to as working papers or workpapers  Aid in planning and conducting future audits

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Audit File
Types of Audit Documentation
 Permanent files: include unchanged
 Permanent audit file information and documentation that is
used from year to year
 Current audit file » Provide summary of policies and
organization of client
» To preserve working papers that have
little change over time.

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Audit file

 Current files: include all documentation

for the current year audit
» Typically arranged and indexed
around accounts in clients’ financial
statement
» Support current year’s audit report

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Professional Skepticism

 Professional skepticism: It is an attitude that

includes a questioning mind, being alert to
conditions which may indicate possible
misstatement due to error or fraud, and a critical
assessment of audit evidence.
 This involves two components:
- Questioning mind
- Critical evaluation of audit evidence

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Professional judgment
 Professional judgement: It is the application of
relevant training, knowledge and experience in making
informed decisions about the courses of action that
are appropriate in the circumstances of the audit
engagement.
 ISA 200 also requires the auditor to exercise
professional judgement in planning and performing an
audit of financial statements. Professional judgement
is required in the following areas:
Materiality and audit risk
Nature, timing and extent of audit procedures
Evaluation of whether sufficient appropriate audit evidence has been obtained
Evaluating management's judgements in applying the applicable financial
reporting framework
Drawing conclusions based on the audit evidence obtained

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